Many observers of the European Sovereign debt saga had long realised that the ECB was the only European institution up to the task of avoiding a breakup of the euro (see for instance Eichengreen 2009 on this site). The newly forged institutions, the ESFS/ESM, are both ill designed and inadequately funded (Manasse 2011).
The sharp criticism of German piecemeal approach, however, forgets that the ECB was created “in the image and likeness” of the Bundesbank; price stability is its core mandate. That was the price to be paid for convincing Germany to give up the Deutsche mark, and to share the same currency with inflation- and deficit-prone Italy. Now that the survival of the euro seems to hinge on the monetisation of southerners’ public debt, one way or another (primary or secondary purchases, anti-spread firewall), it is not surprising that the Bundesbank, backed by the FDP and CSU parties, is simply saying “no”. Weidman’s alleged resignation just proves the case.
ECB President Mario Draghi thus has a problem: not so much with the Bundesbank, which does not command a majority in ECB’s Governing council, but with Angela Merkel, who cannot afford to risk a crack in her coalition government by granting her internal opponents such a precious ally (the Bundesbank) and such a popular accusation, to take sides against the German people and with what the CSU general secretary called Italian “money forgers”. Now it seems that Mrs Merkel also understands that if she doesn’t, she risks being remembered as the leader who buried the euro, at quite a large cost to the German taxpayer. How to break out of this dilemma?
- So far Draghi has been trying to fence off these political tensions by paying lip service to the conditionality attached to a programme of government debt purchase (the Memo of Understanding whose details are already specified in the EFSF statute).
This is unlikely to do the trick.
- A more reasonable strategy would be to present the problem as what it has now grown into: no longer just a European problem but a risk to the global economy.
The reason is clearly the negative impact on global growth (see the recent IMF World Economic Outlook Update, IMF 2012) and on unemployment in Europe and the US, not to mention the potentially global disruptive effect of a disorderly default in Spain and Italy. The Bundesbank may find it more difficult to renege on its international responsibilities than its European ones.
A global problem requires a global solution
Recent episodes of international policy coordination go back to the late 1970s when, at the Bonn Summit in 1978, the G7 leaders agreed on an ambitious (and successful) plan for fiscal and monetary coordination in order to reduce US trade deficit with respect to Germany and Japan. This involved fiscal reflation in Germany, tax cuts in Japan, and a moderate monetary tightening in the US. The combination did the trick.
One of the most recent examples of successful policy coordination among central banks was that of October 2008 when the Federal Reserve announced a reduction in its policy interest rates and other central banks expressed support (namely, the Bank of Canada, Bank of England, ECB, Sveriges Riksbank, Swiss National Bank, and Bank of Japan) (Bernanke 2008). The intervention had a double motivation. The first was to highlight the economic slowdown of their respective economies and the absence of inflationary pressures. The second was to address the shortage of dollar financing outside the US that appeared when European institutions – who had up until then been lending to US non-financial institutions and buying asset-backed securities – were badly hit by the subprime crisis.
Today, the scope for international fiscal cooperation is more limited. That means it is time for another round of monetary policy coordination. The ECB (or the ESFS) should commit to keeping sovereign debt yields within ‘reasonable’ bands, possibly with joint interventions of other central banks. The Fed should engage in a new round of unconventional monetary operations in order to reduce long-term yields. This strategy would hopefully yield relevant economic gains and, this time, large political dividends.
Eichengreen, Barry (2009), “Was the euro a mistake?”, VoxEU.org, 20 January.
IMF (2012), World Economic Outlook UPDATE, 16 July.
Manasse, Paolo (2011), “The trouble with the ESM”, VoxEU.org, 5 April.
Bernanke, Ben (2008), Speech at the Fifth European Central Bank Central Banking Conference, The Euro at Ten: Lessons and Challenges, Frankfurt, Germany. See here.